To adequately keep accurate books, there is a need to stay up to date on the collection of financial information. You would also be looking at integrating a filing and tracking system, opting for an accounting method, as well as periodically analyzing and verifying the information that you have collected.
So, why should you go through this entire hassle as a real estate investor?
Why is Real Estate Accounting Important?
The primary importance of real estate accounting is the fact that it provides a better way to manage your property. However, despite this vital role that it plays, it is often neglected or downplayed.
Here are some main reasons why real estate accounting is essential:
Necessary for Expansion
If you’re looking to expand your holdings which would, of course, imply dealing in hefty financial transactions, you need to understand how these transactions are managed. The average real estate accountant agrees that there are three main benefits of accounting:
- Allows for evaluation of the viability of the business
- Better grip on handling taxes
- Avenue to develop better business strategies
Monitors Business Health
Keeping accurate records of your real estate finance enables you to determine the state of key performance indicators in your real estate business, namely:
- Profit and losses
- Cash flow
- Net worth
- Capitalization rate
- Debt service coverage
These indicators are pivotal to determining whether your business is doing great, or a drastic intervention is required.
Handy During Tax Season
Tax season usually sees a lot of hustle and bustle with many investors in search of a real estate accountant. This is because filing taxes requires digging up necessary information as well as documents.
However, keeping an immaculate account ensures that you’re free of this rush and you adequately prepare your annual tax returns at a leisurely pace. Some other benefits comprise:
- Readily available records in the event of an IRS audit
- Significant reduction in hours billed by your Certified Public Accountant (CPA)
- Adequate records to track and justify deductions claimed
Guides Choice of Business Strategies
Devising a business strategy that works requires sufficient statistics and evidentiary data. The only way to come about this as a real estate investor is via proper real estate bookkeeping.
Reviewing finances from the previous year’s allows you to notice trends or changes and come up with ways to respond. Businesses aim to improve upon previous records and real estate is not left out.
Real estate accounting also provides insight into viable properties as well as those performing poorly. In the event of a need to raise capital, the availability of performance data helps to speed up the process.
Monitors Finances In Real-time
A great accounting system helps to monitor finances in real-time. This involves providing knowledge of available funds at any point in time, as well as keeping an investor on the right track for timely payment of bills and invoices.
Future expenses can also be anticipated, and provisions made. Being able to prepare in advance is one of the major advantages that a proper real estate bookkeeping and accounting system provide.
Elements of Real Estate Accounting
In the realm of real estate finance, there are 5 main elements that transactions have an impact on:
Keeping close tabs on all 5 elements is the proven way to accurate real estate bookkeeping.
Anything that belongs to and can be used for the benefit of your business is an asset. Provided it generates cash, or converts into cash:
- Fixed assets (valuables that would typically be held on to for a while, usually over a year)
- Current assets (valuables that would be converted into cash rapidly, typically within the same year)
Property is considered the principal asset in real estate. When accounting for assets, they would typically be recorded under ‘Fixed assets’ if held for rental income, and as ‘accounts receivable, if held for sale as inventory.
This is the direct counter to an asset. It refers to debt that the company owes:
- Long-term liability (debt that can be paid over a long period, usually exceeding a year)
- Current liability (debt that must be paid within a twelve month period)
In real estate bookkeeping, the typical examples are mortgages, notes payable and accounts payable. That principal liability in real estate is mortgages.
Equity refers to the value of your business and it is easily derived by subtracting liabilities from assets. In equation form: Equity = Assets – Liabilities.
If a property is owned by multiple entities, equity vested might differ and it would typically have to be accounted for in separate books as joint venture interests.
This refers to a payment made for use of assets, which in this case, is your property. In real estate, income is gotten via rent paid by tenants/ residents or as a sale of property.
Apart from repaying debt, certain other payments come up. For instance, if you run a real estate brokerage, you would definitely pay a salary to your agents, and this would be classed as an expense. The typical expenses in a rental management are Property management fee, utilities, property taxes, insurance, repairs and maintenance, depreciation and so on.
Building an Efficient Real Estate Accounting System
Building an efficient and practical real estate accounting system follows several steps. However, here are 4 major steps that must be implemented in the process:
Choosing an Accounting Method
Business accounting is done via one of two methods:
- Accrual accounting
- Cash basis accounting.
Accrual accounting requires a record of each transaction as and when it happened in the relevant period, the end goal is to achieve a high level of accuracy matching income and expenses to right accounting period.
Cash basis accounting on the other hand, recording the transaction when the sales price (rent) is received, or expenses are paid. This method is quite easy to apply in accounting. However, you should get familiar with both the methods before opting the one that you think works for you. While the financial institutions prefer accrual method, you may elect Cash basis which is subject to certain tax basis limitations.
Separate Personal and Business Funds
Keeping personal funds separate from business funds is vital. It is advisable to use a new bank account for income and expenses incurred on your property. This helps efficient real estate bookkeeping and helps avoid tax issues.
Use Multiple Accounts
In addition to separating personal and business accounts, using different accounts for different properties can boost the efficiency of the accounting system significantly. This is because having a separate account allows you easily link credits and debits in the books to the specific property involved.
Review Accounts Regularly
Ideally, reviewing monthly is advised. Doing this allows you to spot possible errors in transactions and statements as well as keep tabs on outstanding payments (accounts payable or accounts receivable). For this, you could opt to hire a professional real estate accountant as well.
Accounting in real estate is a necessary, yet grossly underrated aspect of property management. This ultimate guide covers the most essential aspects of the theme, ensuring that you are equipped to run your investment smoothly.